Why low inflation reflects weak sales but is a long-term positive

The most widely reported inflation rate is the CPI (Consumer Price Index). Since May 2012, US consumer inflation (measured by the year-over-year change in the consumer price index) has generally stayed below 2.0%. In August 2013, the overall inflation rate stood at 1.5% compared to the same month last year, while the rate excluding the more volatile food and energy costs held at 1.8%.

Inflation occurs when demand increases more than capacity growth can keep up. This can happen when excess money is being borrowed and spent. This can become dangerous because high inflation could lead to hyperinflation and erode the value of the dollar. That could lead to an economic collapse, as people wouldn’t want to hold US currency anymore. And when people don’t believe in US currency, economic activity could collapse.

On the other hand, when inflation is low, there isn’t an incentive to spend as much (which is a why the central bank fears deflation because price declines could motivate people to spend less and less). It also suggests demand isn’t increasing more than capacity, which could deter business spending. So it’s part of Federal Reserve’s mandate to keep stable inflation by influencing how fast and how much money is circulating.

With the labor market not showing significant recovery, demand has been subdued. Prices for housing (which makes up the largest portion of consumers’ expenditure) aren’t rising as fast as they did pre-2008 after the bubble burst. Food inflation also slowed as farmers increased their fertilizer use, and growth in emerging markets has fallen from the peak growth that took place over the first eight years of the 2000s.

In the United States, a push towards energy independence has spurred increases in oil and natural gas production, which kept prices and transportation costs low. Hybrid electric and more fuel-efficient cars contributed to tame inflation. Throughout the early 2000s, China was all about economic growth. Now, China is focusing on being more energy-efficient and environmentally conscious on concerns of possible social unrest.

Falling inflation is often perceived as a negative because it could reflect the inability of food retailers like McDonald’s Corp. (MCD), Yum! Brands Inc. (YUM), Chipotle Mexican Grill Inc. (CMG), and AFC Enterprise Inc. (AFCE) to increase their selling price. Weak inflation also signals weak employment growth, which could limit same-store growth in the short- to medium-term if these companies didn’t have a unique and attractive business model. However, low inflation also means the Fed will keep its loose monetary policy in place, which is likely to be positive for these stocks over the long run. But the CPI isn’t the inflation metric the Fed follows most closely.

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